Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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Josef Tošovský has given a very interesting and comprehensive picture of the issues of bank restructuring in a transition economy. Although the Czech case is not necessarily representative of transition—as it is usually considered among the best situated of the transition economies—the paper covers some important ground. More specifically, it is sometimes argued that the Czechs have done “everything right,” and their case deserves special attention; this is a special stimulus for discussion.

My discussion will concentrate on three main subjects. First, having in mind my comparative advantage in macroeconomics, I would like to recall the necessary conditions for bank restructuring. Second, in an issue that touches on political economy, I will address why, in spite of repeated statements on the need of speedy action, bank restructuring is often delayed or neglected. Third, I switch to a topic in industrial organization; can one define an optimal banking industry structure? The need for a numeraire, a standard against which to compare the number of banks, seems obvious for taking adequate policy measures.

Necessity of Price Stability

It seems clear that in the area of macroeconomic policy there is a broad consensus on the issue of inflation. It is usually maintained that low inflation is a necessary condition not only for higher and sustained growth but also for effective bank restructuring. After achieving a relatively low inflation, however, complacency can set in, and stability sometimes slips down the list of economic priorities. This might be dangerous in the long run. One often hears: “Why worry now? Wait for inflation to reappear and then deal with it.” Yet inflation must be dealt with before it appears, and not be “shot at” only after it has been spotted. Once inflation is revived, it is usually too late to avoid significant inflationary costs for the economy.

It is worth repeating as well that without stability efficient financial intermediation through banks is not possible. It is equally true that stability per se is not enough to deliver increasing welfare (growth and equity), and there is an obvious need to link macroeconomic policies with structural measures to achieve sustainable economic growth.

The Czech Republic is still in transition, although the focus of discussion has moved from macroeconomic issues (stability), which were the primary problem at the beginning of transition, to structural ones, such as micro-oriented questions (primarily banking and enterprise reform).1 But both cases deal with conditions for sustained and high economic growth (prosperity) and income distribution. Without economic growth, policymakers are basically playing a constant-sum game, or something that was usually called “redistribution” under socialism. Therefore, inflation fighting should be always on the minds of central bankers.

Bank Rehabilitation in Transition

Joseph Schumpeter once said that the only important institution in capitalism is the bank. In other words, banks should collect savings in the economy and be responsible for the efficient allocation of resources. This applies even more to transition economies. But, most transition economies are faced with both shallow and narrow financial markets. With underdeveloped capital markets and relatively high country risks, raising equity capital either on the stock exchange or through direct foreign investments seems more difficult than in developed market economies. Thus, enterprises willing to grow must rely on self-financing or bank lending. Banks play a very important role in the overall financial system in almost all transition countries.

As discussed with regard to Poland (see Chapter 14) and the Czech Republic, banking in transition countries needs restructuring. After institutional changes (moving from monobanking to multitier systems), banks in transition economies need, first, to increase the efficiency of resource allocation and, second, to encourage national saving (which is a separate subject not be dealt with here).

In almost all transition economies, banks cannot fully play their role of efficient allocators of economic resources. Starting in most cases from monobanking, old (usually state-controlled) banks are not prepared to measure risks adequately, and they are overstaffed and burdened with bad loans. Their decisionmaking is often influenced more by political considerations and less by sound banking principles. New, emerging private banks are usually so small that their influence is not enough to create a competitive banking environment. Thorough rehabilitation and restructuring of banks are essential to create sound banks. Proper allocation of resources will consequently increase macroeconomic efficiency. Therefore, after stabilizing the economy, bank rehabilitation and restructuring (linked with enterprise restructuring) seem to be the highest priorities for policymakers.

Those issues are well known and analyzed, and a lot of significant work exists on this subject. In other words, the normative approach to the needs of a well-functioning banking system in a transition economy has received significant attention in the professional literature. But, the main questions, like why the best policies are or are not chosen, when they are chosen, and why they are or are not implemented, have been much less analyzed.

The writings in this volume repeatedly stress that if banking problems appear it is essential to act quickly and decisively. In reality, bank rehabilitation (in transition) proves to be a very slow process, which, if neglected, may lead to serious banking sector problems and ultimately a banking crisis. For example, it was known that Albania and Bulgaria were heading toward crisis, but nothing was done to prevent it. Needless to say, banking sector problems are not restricted to transition economies. Since 1980, about 130 countries have experienced significant banking sector problems, while 36 have had banking crisis.2 So, the real question is: Why is it difficult to rehabilitate banks, preferably before a full-blown banking crisis with high costs erupts, if this process is so important?

The usual answer is that bank rehabilitation (including isolating bad loans, as well as recapitalizing and restructuring banks) is very costly, and budgetary resources are scarce. Double-digit numbers on the ratio of costs to GDP are not rare. Yet the “high cost” argument is only partially true, given that, among other things, bank rehabilitation appears to be a redistribution problem. With budgetary expenditures of about 50 percent of GDP, as is the case in most transition economies, devoting a couple of percentage points to bank rehabilitation does not look like an unattainable objective. If one realizes this redistributional dimension, then the argument of lack of finance is no longer valid. It is just an issue of realizing the importance of this process. Deciding which budgetary expenditures must be lowered and which population should be “hurt” today—deciding how to handle the intertemporal distribution of restructuring costs, such as whether the present generation or future generations should pay for this effort and to what extent—falls into the domain of public choice and not of raising additional budgetary revenues for bank rehabilitation.

It is essential that bank rehabilitation and recapitalization be done in a transparent way: through the employment of budgetary resources (taxes) with clearly stated rules and realistic estimates of costs of this “rescue operation.” Financing through an inflation tax—by monetizing the budgetary deficit—should be avoided at any cost.

If financing is not a problem (at least not the main one), why then is bank rehabilitation postponed? Without clear political support, banking sector reforms (including rehabilitation) can hardly be effected. Note that any budgetary allocation of public resources cannot be achieved without the political approval of the parliament. Therefore, political and economic goals may diverge. Ultimately good economic policy is good politics. But, in the short run, their goals can conflict. Therefore, it is essential that the political economy of policymaking be well understood and that the goals and consequences of bank rehabilitation be well explained to politicians and the general public.3 The question is why are optimal decisions in bank rehabilitation not taken?

Bank rehabilitation is usually faced with significant resistance from various constituencies. Resolving systemic banking problems is a practical exercise in multiple enterprise restructuring. This again means substantial redistribution, with some interest groups worse off after the restructuring. Micro-reforms involve real names and social security numbers: they hurt very real people. Besides, a large number of qualified people are required to work on rehabilitation and restructuring plans for banks, and in transition economies experienced financial experts are usually in short supply. Therefore, it might be argued that in bank rehabilitation in transition economies the lack of human capital represents a much bigger problem than the lack of financial resources.

This is not typically the case with macroeconomic stabilization programs, which are more glamorous (occasionally being announced on TV or trumpeted by a dramatic drop in inflation) and can be planned and implemented by few specialists and affect the society as a whole (usually by increasing their welfare).

In transition economies, banks need restructuring because their past loans were granted mostly on the basis of political criteria (without adequate measurement of the risks involved) and not on the basis of sound banking practices; otherwise their assets would not have turned sour at such a high rate. These banks were usually state controlled and overstaffed, and politicians could easily influence the decisionmaking process. Banks were managed by people closely linked to the political elite and were expected to fulfill certain duties (“support the economy”) and not necessarily to protect bank liabilities (deposits and capital). Therefore, resistance to bank rehabilitation may come from several quarters:

  • Politicians often strongly resist thorough bank rehabilitation. Under central planning, bank managers were appointed by the political elite, not regular shareholders whose interest would have been profit maximization. If this political elite has not withdrawn from the scene (or has reemerged as is the case in some transition countries), it may be difficult to change the management of a bank during the process of rehabilitation. Politicians are aware that they will have much less power if new management, over which they have little influence, is appointed. Friendly management can grant loans for wages to workers on strike, finance local sports teams, support certain newspapers, and so forth.
  • Bank managers have clear vested interests within the existing power structure (the very structure that caused banking problems). High wages and political influence are strong enough motives for their active opposition to any change that implies the loss of their position. They may go along with rehabilitation plans as long as they themselves bear no consequences on the account of previous behavior. However, having the same management in supposedly rehabilitated banks entails a clear moral hazard problem.
  • Personnel of a bank resist rehabilitation and restructuring because these processes create uncertainty and engender a fear of layoffs; most of the old banks are overstaffed and need serious downsizing.
  • State-controlled enterprises more often than not based their existence on soft loans from state-controlled banks. It was common that the largest debtors of a bank were sitting on that bank’s supervisory board, creating interlocking relationships and conflicts of interest. Those firms would rather engage their resources in rent-seeking activities to retain the status quo than do the arduous task of restructuring a company to be profitable in a competitive environment. Thus, the management of those enterprises as well as their employees can be expected to resist bank rehabilitation.

In short, use of sound banking principles in decision making would significantly hurt large groups of people. Therefore, one should expect various interest groups (managers of banks, employees of banks, enterprises whose existence depends on soft loans, groups of politicians, and so on) to offer strong resistance to banking reform. Private interests are put before social goals. Thus, obstacles to bank rehabilitation are again more in the domain of political economy (power struggle and redistribution) and much less in that of strict financing issues.

If banks are not rehabilitated, if they continue to extend loans based on political criteria, in short if insolvent banks remain in the system, severe banking problems or even banking crises will emerge sooner or later. The costs of banking problems are frequently huge, sometimes in double-digit percentage points of GDP over a couple of years (like in the cases of Chile, Hungary, or the Czech Republic), and can severely affect the overall fiscal position. That is why it is extremely important to reach a nationwide political consensus on the necessity of bank restructuring before a crisis erupts. Without this consensus, bank rehabilitation cannot proceed.

Even if this consensus is reached, the problems are not eliminated. Governments seldom act quickly and decisively, and once political decisions have been taken their full implementation can be postponed for various reasons: lobbying to overturn the decision, forthcoming political elections and fear of rehabilitation costs, simple corruption, obstruction from various levels of bureaucracy, and lack of qualified staff to implement radical banking sector reforms, among others. Two results may arise from these impediments:

  • Delay: The government realizes and announces bank rehabilitation but does not take immediate measures (owing to the lack of human capital, funds—because of improper budgetary planning—or broad political support). Implementation is as important as taking the optimal decision.
  • Dilution: Measures undertaken to rehabilitate banks are not radical enough. In this case, bank rehabilitation has to be repeated again and again.

If delay or dilution happens, future bank rehabilitation will be needed and it may be more difficult and more costly. Arguably, the only thing worse for the economy than doing nothing about warranted bank rehabilitation (and thus increasing the risk of the collapse of the financial system) is improper rehabilitation, because the latter substantially decreases the credibility of the authorities and increases the costs of future bank rehabilitation.

In that regard bank privatization is the area where transition economies should pay additional attention. Starting from monobanking, then moving to state-owned two-tier systems, transition economies need to privatize their banking industries. Private ownership definitely improves efficiency, and without privatization it is difficult to change the decision-making process in banks.

To summarize, commercial banks play a significant role in the transition process. But to fulfill this demanding task, the banking sector must be restructured and depoliticized. In the long run, privatization of banks, increasing competition in the banking industry, and integration into world financial markets are the best remedies for ailing banking sectors in transition economies, but the state must institute immediate action. Financial stability (in the form of a sound banking sector) is a public good, and the state must work to promote it.

One big lesson from the existing transition experience is that transition is not a short-lived, one-shot effort, but a long-standing battle, a marathon for which a country has to be well prepared both psychologically and physically. As transition has no alternatives (at least no reasonable ones), it is best to face this truth. Much has been achieved, but formidable obstacles still lie ahead. It is therefore important to remember that economic reforms will be rewarded in the future with the increased well-being of the population at large in the increasingly global world economy.

Can One Define Optimal Banking Structure?

Finally, I would like to say a few words about the normative approach to bank rehabilitation. By end-December 1996, Croatia had licensed 60 commercial banks (or Deposit Money Banks). The usual reaction to this fact is, “This is too big a number. You have to close down some banks and strengthen licensing procedure. Why don’t you consolidate?” This situation raises a couple of questions.

Are there scale economies in the banking industry? Most probably there are, especially in data processing technologies. But, if so, what is the slope of the long-run average cost curve, or where is the minimum of the cost function (meaning equality of marginal and average costs)?

An additional unknown relates to the larger theme of bank soundness. On one hand, if Croatia truly has too many banks, not all of them can be sound. Thus, too large a number would imply a potential banking crisis and an unsound banking industry. That automatically puts all the mentioned goals (efficient intermediation and sustained growth) in jeopardy. Further, if we analyze the banking industry from the viewpoint of contestability theory, then the number of banks does not say anything about the competitiveness of the market. But another problem appears: How contestable is the banking industry? Can we define sunk costs for banks? Does potential entry from big foreign banks force domestic banks to act competitively?

Under the traditional approach, one could infer that sunk costs are relatively high, and thus the market is not contestable (high exit costs). But the development of new technologies might change this view. Assume that in a monopolistic domestic market there are barriers to entry for foreign banks. According to the American Bankers Association, the cost per transaction in a banking branch averages $1.07, through an automated teller machine (ATM) $0.27, and through the Internet only $0.01, or a hundred times less than through the branch. In an increasingly interconnected world, with wider access to computers (network stations) and the Internet, it is not unimaginable to manage one’s account in New York from Prague. Even cash transactions can be easily handled via e-money or ATM. Of course, this is only an additional speculation, but, definitely, cost curves for banks are not only very difficult to measure but also shifting dynamically.

Finally, if scale economies are strong, a couple of financial giants are likely to dominate the field—in which case even five banks for countries like Croatia or the Czech Republic might be too many. For example, a recently announced privatization of Creditanstalt by BankAustria will create a bank with the same number of employees as in the overall Croatian banking industry (about 18,000), but the assets of the new bank will be ten times as large. Does that mean that Croatian banks (compared with banks in Central Europe) are too small? Niche markets might be a counterargument, but again complexities arise when one wants to have operational rules of thumb. As such, this remains an area where a lot of work should be done.

Importance of Public Support for Bank Rehabilitation

Lastly, having in mind all the obstacles to bank rehabilitation, it is important to keep in mind public support for this process. Policymakers—those who restructure banks—must constantly educate both the population and politicians. They have to make sure that goals are well defined. The public’s high expectations, especially in transition economies, must be dealt with, or else those carrying out the needed reforms, the costs of which have to be borne in the present for the sake of future benefits, might be ousted from office. The public and politicians have displayed a surprisingly poor knowledge of modern economic principles. Thus policymakers must educate on a daily basis. What exactly should they say? Expect only hardship? Or prepare for immediate benefits? Both politicians and economists will be expected to supply adequate answers to those questions.

This is not only the case in transition economies. An American economist described his work in the following way: “It’s mostly a matter of getting rid of bad ideas but, it’s like flushing cockroaches down a toilet—sooner or later they just come back.”4

It seems clear that transition economies have no alternative but to pursue sound, credible, transparent, and prudent long-term policies. The banking sector plays a crucial role in those policies. “Right” economic policies may not always be popular with voters or politicians, but the marginal rate of substitution for the alternative scenario is such that no professional economist should accept it. It is our duty to send this message urbi et orbi. The moral would be: Never neglect public opinion, but sound economic principles in both macro and microreforms must be respected and never compromised in the long term. There is no substitute for market discipline.

As Eddie George so eloquently showed (see Chapter 5), banking is still very special. Prudence, honesty, and adequate regulation should be the guiding principles in protection of the public interest. In transition economies (and others as well), it seems realistic to expect problems in the financial system. Thus, banking failure can be (relatively) easily predicted. If a bank fails, the main problem is that—because of asymmetric information—it is not possible to say whether “an honest banker has honestly failed, or a dishonest banker has dishonestly failed.”5 Perhaps this shall continue to be a bigger secret than Swiss bank accounts.


For a good discussion of the macroeconomic issues, see M. Blejer and M. Škreb, eds., Macroeconomic Stabilization in Transition Economies (New York: Cambridge University Press, forthcoming).


C. J. Lindgren, G. Garcia, and M. I. Saal, Bank Soundness and Macroeconomic Policy (Washington: International Monetary Fund, 1996).


See, for example, D. Rodrick, “The Political Economy of Economic Reforms,” Journal of Economic Literature, Vol. 34 (March 1996), pp. 9-41.


Paul Krugman, Peddling Prosperity (New York: W.W. Norton, 1994).


A. Hillman and W, Ursprung, “The Political Economy of Financial Sector Reform in Transition,” paper prepared for Second Dubrovnik Conference on Transition Economies, Dubrovnik, June 26-28, 1996.

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